The Unit Valuation Principle for Property Tax Purposes

Approaches and Methods

This third of a five-article installment discusses the application of the unit valuation principle. The discussion continues with a summary of the generally accepted unit valuation approaches, methods, and procedures.

Read Part I here. Read Part II here.

Introduction

This installment is part three of a five-article series related to the unit valuation principle for ad valorem property tax purposes. Part I summarized what analysts need to know about the application fundamentals related to the unit principle valuation of complex, utility-type properties for property tax compliance, administration, and controversy purposes. Part II explained when it was appropriate to apply the unit principle to value such utility-type property. Part III continues the discussion with a summary of the generally accepted unit valuation approaches, methods, and procedures.

Unit Valuation Principle Approaches and Methods

As the name implies, the unit valuation principle is a “principle”. It is not the unit approach. It is not the unit method. It is the unit principle. Legal counsel and other individuals who may be casually familiar with the property tax discipline may be excused for misusing technical valuation jargon. Analysts, property appraisers, property tax administrators, and other professionals who practice in this discipline should be expected to know the difference between a principle, an approach, and a method. And such individuals should be expected to use the discipline’s technical jargon accurately and correctly.

As with all types of property valuation analyses, there are three generally accepted approaches in the unit principle. These three generally accepted approaches are typically called the cost approach, the market approach, and the income approach. As with the term “principle”, the term “generally accepted” is professional jargon. Analysts and property tax administrators should be familiar with, and use, this technical jargon. The three valuation approaches are not “traditional” approaches. They are not “common” approaches. They are not “typical” approaches. They are generally accepted approaches. Professional practitioners in the property tax discipline should be expected to use generally accepted valuation jargon.

There are several generally accepted methods within the cost approach. These generally accepted methods include the following:

• The historical cost less depreciation method
• The reproduction cost new less depreciation method
• The replacement cost new less depreciation method

Historical cost indicates the cost that the first property owner paid to purchase or construct the subject property. Historical cost is typically reported in the financial accounting records of the subject property owner. If the property owner has not been acquired in a change of control transaction, historical cost is typically presented on the owner’s balance sheet prepared in accordance with GAAP. If the property owner has been acquired in a change of control transaction, the property’s historical cost may not be presented on the owner’s balance sheet. In fact, the property’s historical cost data may no longer be available in the continuing property records of the new owner. The price that the current owner paid for the property is called the original cost. After a change of control transaction, the current owner reports the original cost (not the first owner’s historical cost) on its balance sheet.

The original cost is typically determined through the financial accounting process of an acquisition purchase price allocation. Under the current financial accounting standards, the property’s original cost is based on the fair value (as concluded in an independent appraisal) of the acquired property as of the acquisition date. If the historical cost data are available, analysts will typically rely on those data in the development of the historical cost less depreciation method. If the historical cost data are not available, and only the original cost data are available, then—out of necessity—analysts will have to rely on those data in the development of the historical cost less depreciation method.

It should be noted that the historical cost less depreciation method is rarely applied in the development of a summation principle valuation. In contrast, the historical cost less depreciation is the most frequently applied cost approach method in the development of a unit principle valuation. And the historical cost data are most typically extracted from the property owner’s balance and supported by the property owner’s financial accounting continuing property records.

Reproduction cost new indicates the current cost to recreate an exact duplicate of the subject unit of property. The duplicate property would be constructed with the same material as the subject property. The duplicate property would be configured in the same layout and design as the subject property. In all material respects, the duplicate property would look like, and function like, the subject property. Reproduction cost new could be measured by developing a discrete current construction/purchase cost estimate for all the subject property. That current cost estimation procedure may be possible if there are detailed drawings and schematics available regarding all the subject property. More typically, the reproduction cost new is measured through a process of trending the property’s historical cost data. The cost trend factors should reflect the inflation (or deflation) indices applicable to the type of subject property; by property vintage. Property vintage relates to the age of the property since it was first placed in service. The reproduction cost new less depreciation method is sometimes (but not typically) developed in a unit principle valuation.  

Replacement cost new indicates the current cost to create a new functional equivalent of the subject property. The replacement property would be constructed/purchased from modern materials. The replacement property would have a modern design and layout. All of the subject property’s functional inadequacies are generally eliminated in the design of the replacement property. Replacement cost new measurements typically require an engineering redesign and engineering cost estimate of the ideal replacement property. The replacement cost new less depreciation method is a typical cost approach method in the development of a summation principle valuation. The replacement cost new less depreciation method is rarely applied in the development of a unit principle valuation.

All cost approach methods require the identification and measurements of all forms of appraisal depreciation. Appraisal depreciation is typically segregated into these three forms or types:

• Physical depreciation
• Functional obsolescence
• External obsolescence

Physical depreciation represents the physical wear and tear of tangible property. Although physical depreciation can be quantified in different ways, it is often measured by what is called the age/life method. In the development of unit principle valuation, physical depreciation is often measured by reference to the amount of accumulated depreciation reported on the property owner’s balance sheet. For financial accounting purposes, accumulated depreciation is generally intended to capture the decrease in historical cost associated with the physical wear and tear of tangible property.

Functional obsolescence represents the inadequacy or the superadequacy of the subject property (typically in contrast to the ideal replacement property). Functional obsolescence is often measured by either the cost to cure method or the capitalized excess operating expense method. In a unit principle valuation, functional obsolescence is typically measured at the total unit level (rather than at the individual property component level). The accumulated depreciation balance reported on a property owner’s balance sheet typically does not capture the valuation impact of functional obsolescence.

External obsolescence has two principal components: locational obsolescence and economic obsolescence.

Locational obsolescence is a decrease in property value related to locational factors. Locational obsolescence typically impacts real estate. Locational obsolescence typically does not impact on the value of a total unit of property. A typical example of locational obsolescence would be the construction of a new high-rise building that blocks the desirable lakefront view of an office building or a residential apartment building. Economic obsolescence is a decrease in property value that occurs when the property owner cannot earn a fair rate of return on the ownership or operation of the subject property.

Like locational obsolescence, economic obsolescence must be caused by factors outside of (or external to) the subject property. A typical example of economic obsolescence could be decreased property income due to changes in economy-wide or industry-wide supply and demand factors. There are many methods that appraisers can use to measure economic obsolescence. The capitalization of income loss method is a measurement method that is typically applied in the development of a unit principle valuation.

The accumulated depreciation balance reported on the property owner’s balance sheet typically does not capture either the locational obsolescence component or the economic obsolescence component of external obsolescence.

There are several generally accepted methods within the market approach. Two of the generally accepted market approach methods include the following:

• The direct sales comparison method
• The stock and debt method

The direct sales comparison method involves the extraction of valuation pricing multiples from the recent sales of either comparable or guideline units of property. The pricing multiples can relate to either financial metrics (e.g., unit revenue, operating income, net income) or operational metrics (e.g., number of units produced, number of units of capacity, number of customers in the unit). Pricing multiples are extracted from each of the selected market sale transactions. The analyst analyzes the market sale unit of property and compares those units to the subject unit. The analyst selects subject unit-specific valuation multiples based on this comparison. For example, the analyst could compare the relative size, location, growth rates, profit margins, and returns on investment of the subject unit and the selected sale units. The analyst applies the selected valuation multiples to the subject unit financial fundamentals or operational fundamentals in order to develop subject unit value indications.

Of course, the analyst should only rely on arm’s length, independent sale transactions as a source of valuation pricing multiples. And the analyst should consider the degree of comparability of the sale units compared to the subject unit. Ideally, the analyst would identify a sufficient number of recent comparable unit sale transactions. Comparable units would look like the subject unit from an operational perspective. If sufficient comparable sale units are not available, the analyst may select and analyze guideline unit sale transactions. The guideline units may not be perfectly comparable to the subject unit. However, the guideline sale units should be sufficiently similar from a market participant’s risk and expected return perspective to provide meaningful valuation guidance (hence the name guideline) to the analyst.

The stock and debt method is an indirect method of valuing the subject unit. Effectively, the stock and debt method values the unit property owner; instead of the unit property. In the stock and debt method, the analyst values the debt instruments and the equity instruments of the unit owner’s business enterprise.

The subject unit debt is valued by reference to the amount of the long-term, interest-bearing debt outstanding of the unit owner. This long-term debt amount is typically extracted from the unit owner’s balance sheet. Unless the subject debt has embedded interest rates that are materially different from the valuation date market interest rates, the unit owner’s long-term debt is typically valued at face value.

The subject unit equity is valued by reference to valuation pricing multiples extracted from selected publicly traded comparable companies or guideline companies. The analyst selects the publicly traded companies. The companies are either comparable companies (companies that look very similar to the subject unit owner) or guideline companies (companies that are similar to the unit owner from an investment risk and expected return perspective). The analyst analyzes the market-derived pricing multiples and selects unit-specific pricing multiples based on the relative size, growth, profitability, and return on investment of the unit owner compared to the selected companies. The analyst applies the selected pricing multiples to the unit owner’s financial fundamentals to develop a value indication of the subject unit owner’s equity.

The analyst adds the debt value indication and the equity value indication to indicate the value of the unit owner’s total debt and equity. The analyst then applies a fundamental (and conceptually dubious) assumption: that the value of the unit owner’s debt and equity is equal to the value of the subject unit property.

The stock and debt method is a valuation method that is unique to the unit valuation principle. There is no corresponding market approach method within the summation valuation principle.

There are several generally accepted methods within the income approach. Two of the generally accepted methods include the following:

• The direct capitalization method
• The yield capitalization method

In a unit principle valuation, both the direct capitalization method and the yield capitalization method conclude the present value of the operating business income of the business enterprise that owns the subject unit of property. That present value is calculated by applying either a direct capitalization rate or a yield capitalization rate where the components of those rates are extracted from capital market (i.e., publicly traded stock and bond) data. Based on this summary description, it should be obvious that the direct capitalization method and the yield capitalization method are fundamentally different between the unit valuation principle and the summation valuation principle.

In the direct capitalization method, a normalized measure of income is divided by a direct capitalization rate to derive a value indication. The income to be capitalized should be expected future income, not historical income. And the income should be normalized. That means the expected income should represent a typical 12-month period in the future. Extraordinary or nonrecurring income and expense items should be eliminated from the normalized income.

The income measure can be operating income or either before tax or after-tax net cash flow. It is important, of course, for the capitalization rate to be appropriate to the measure of income to be capitalized. In other words, the derivation of the capitalization rate should correspond to the measure of income subject to capitalization. While different measures of income can be applied, after-tax net cash flow is the most typical income metric. That is because most market participants analyze after-tax net cash flow in their transactional valuation analyses. Also, most available capital market data (used to derive the capitalization rate) are after-tax, cash flow-related data. The income applied in either income approach method is the business operating income to be generated by the unit of property in place on the valuation date.

There are various methods available to calculate the direct capitalization rate. The most typical method is represented by this formula: direct capitalization rate = yield capitalization rate – expected long-term growth rate. The yield capitalization rate is the applicable present value discount rate, most typically the after-tax weighted average cost of capital for the subject unit owner. The expected long-term growth rate is the growth rate in the income metric that can be achieved by the unit of property in place on the valuation date. That is, it is not a revenue growth rate or an industry growth (unless that rate is also applicable to the subject unit). It is not a business enterprise growth rate. It should be a property unit-specific growth rate.

The direct capitalization method value indication is the expected normalized income divided by the direct capitalization rate.

In the yield capitalization method, the unit’s expected future income is projected for each individual year in a discrete projection period. There is no set number of years in the discrete projection period. Analysts typically use a projection period for which future results of operations can be projected with a reasonable degree of accuracy. Again, the projected income relates to the business operations generated by the unit of property. The income metric can be operating income or net cash flow. After-tax net cash flow is the typical income measurement.

The yield capitalization rate is the present value discount rate. That rate is typically the after-tax weighted average cost of capital for the owner of the property unit. In any case, the discount rate should be calculated on a consistent basis to the income subject to capitalization.

A terminal value (or residual value) is calculated at the conclusion of the discrete projection period. The above-described direct capitulation method is typically applied to calculate the terminal value. In that calculation, it is noteworthy that the expected long-term growth rate at the end of the discrete projection period may not be the same rate as applied in the direct capitalization method (i.e., the rate that is applicable at projection year one).

The sum of the present value of the discrete projection period income plus the present value of the terminal period value equals the yield capitalization method unit value indication.

In the unit principle valuation, analysts attempt to apply as many valuation approaches and methods as possible. Of course, it is not always possible to apply all three-unit valuation approaches in each analysis.

Analysts synthesize the various value indications to conclude a final unit value. That reconciliation process can be either quantitative or qualitative in nature. In either case, analysts assign more emphasis to the valuation approaches and methods that engender the greater amount of appraiser confidence. In assessing the quantitative or qualitative emphasis to apply, analysts typically consider the quantity and quality of data available within each valuation approach and method. And analysts typically also consider which valuation approaches and methods are relied on more by market participants in the subject industry.

The valuation synthesis and conclusion indicate the value of the subject total unit of property. As explained below, that total unit value may include property or value that is not subject to property taxation. Accordingly, the analyst may have to adjust the total unit value to conclude the value of the unit of taxable property. The next section discusses the various property types and value influences that may be included in the unit value.

Property Components Included in the Unit Value

As mentioned above, the taxpayer business enterprise (the property owner) is not the same thing as the unit of property. There are different property components in the business and in the unit. And there are different value influences on the business and on the unit. One difference is that the unit only includes property (tangible and intangible) that is in existence on the valuation date. The business includes investors’ expectations of future property (tangible and intangible) that will be created by or acquired by the business in the future.

The valuation of both the business and the unit involves analyses of future income. But the unit valuation includes the present value of the future income expected from tangible and intangible property in place (e.g., current railroad rolling stock and current contracts/customers). In contrast, the business valuation includes the present value of future income from tangible and intangible property that does not yet exist (e.g., expansionary rolling stock above direct replacement levels and new contracts with new customers not currently serviced). These future properties may be internally created, purchased one at a time, or acquired in a future merger or acquisition.

Investors (i.e., market participants) will pay a price for this expected future income. That price results in a value increment to the business enterprise that is not related to the unit of property in place. That value increment is often referred to in the financial literature as the present value of growth opportunities (PVGO). This PVGO attaches to the business value, and not to the unit value.

Many of the above-mentioned valuation variables are derived from capital market data. Capital market data means data related to publicly traded stock and bond markets. Examples of such capital market-derived valuation variables include discount rates, capitalization rates, required rates of return, pricing multiples, growth rates, and others. Securities that trade on capital markets are affected by value influences that do not affect the unit of property that does not trade on capital markets. Such securities have value attributes that the unit of property does not.

Some of these value influences or value attributes include the following:

• Liquidity: public securities are perfectly liquid at minimal trading costs; property is illiquid with large trading costs
• Division: public securities are divided and transferred into small dollar investment units; property is typically transferred in large dollar blocks
• Diversification: the securities owner typically owns a diversified investment portfolio; the property owner typically operates in one industry
• Limited liability: security owners have liability limited to their investment; property owners typically have unlimited liability
• Appreciation: investors in public securities expect their investments to appreciate over time; owners of tangible property (and most intangible property) expect their investment to depreciate over time
• Reinvestment: investors in public securities do not need to make periodic reinvestments to maintain value; owners of tangible and intangible property make continuous expenditures to maintain and replace (i.e., maintain the value of) their property

When analysts apply capital market-derived data in the valuation of the property unit, they are including investment attributes—and positive value influences—that are not present in the subject unit of property. These value influences or value attributes are not property at all; either tangible or intangible. And, when analysts include PVGO in their analysis, they may be overstating the unit value. This is because the PVGO represents the value of future property that does not yet exist on the valuation date.

The typical unit principle valuation concludes the value of the following bundles or categories of unit property:

• Financial or working capital assets: these accounts are recorded on the owner’s balance sheet, but they are not considered intangible assets for financial accounting purposes; they are intangible property for taxation purposes; examples include cash, marketable securities, accounts receivable, prepaid expenses, and materials and supplies inventory
• Real estate and tangible personal property: this familiar category includes land, land improvements, buildings, rights of way, machinery and equipment, trucks and autos, airplanes, locomotives and rolling stock, and pipelines
• Intangible personal property: this category includes (but is not limited to) many of the intangible assets recorded for financial accounting purposes; examples include patents, trademarks, copyrights, computer software, proprietary technology, assembled workforce, contracts, licenses and permits, and customer relationships
• Goodwill: after a business acquisition accounted for as a business combination, goodwill is recorded on the owner’s balance sheet as an intangible asset; goodwill typically represents capitalized excess earnings that cannot be associated with other tangible and intangible assets; goodwill may not be considered personal property
• Investments and other assets: this category includes long-term investments (such as unconsolidated subsidiaries), non-operating assets (sch as land held for future development), and assets held out for sale
• Regulatory assets: many regulated industry participants are required to hold and record various regulatory asset accounts (often related to customer deposits and long-term receivables)

Depending on how the unit valuation was developed, the concluded unit value could also include the PVGO and the investment attributes described above.

The takeaway is that the typical unit value conclusion includes many more property types or categories than just real estate and tangible personal property. Depending on the taxing jurisdiction, not all the unit property types may be subject to property taxation. In that case, the analyst (and the property tax administrator) will have to adjust the concluded unit value to conclude the value of the subject taxable property.

Some observers note that the unit valuation market approach methods and income approach methods are more susceptible to concluding this expansive list of property categories. In contrast, the unit valuation cost approach methods are less susceptible to including this expansive list of property categories. This observation is generally correct. However, the cost approach methods can still be influenced by each of the above listed property types; particularly in the measurement of economic obsolescence. The unit’s total income has to provide a fair rate of return on the value of all the unit’s property types. If part of the unit total income is allocated to categories other than tangible property, that means there is less income available to allocate to the tangible property. That lesser income allocation could result in—or increase the amount of—economic obsolescence in the cost approach analysis.

Property (and Other) Components in the Business Value

There is a well-defined relationship between the unit’s tangible property value, the total unit value, and the property owner’s total business value. That relationship is summarized next.

In a unit principle valuation, the tangible property value includes the real estate and tangible personal property only. To conclude the tangible property value, the analyst first concludes the total unit value. Then the analyst subtracts all property categories that are not tangible property; such as the owner’s financial/working capital accounts and any intangible personal property.

In the unit principle valuation, the total unit value includes all of the property (and other) categories described above. In the application of the unit valuation approaches, the analyst should be careful to select and apply valuation variables that do not include (or that specifically exclude) PVGO, non-property investment attributes, and non-operating and other assets.

In the business valuation of the owner’s enterprise, the analyst will select and apply valuation variables that do capture all of the value of the entity’s PVGO, investment attributes, and non-operating and other assets. That is, the unit value plus PVGO plus investment attributes value plus non-operating and other assets value equals the business value.

If the property owner enterprise sells in a merger or acquisition transaction, the transaction sale price should approximately equal the business value. That is because all the elements of the business enterprise (including any non-property elements) will transfer in that acquisitive transaction. However, the analyst, and any party that relies on the unit valuation, should understand that the owner’s business value likely includes both taxable property categories and value influences that are not subject to property taxation in the subject taxing jurisdiction.

The relationship between these different valuation subjects may be understood by visualizing three concentric circles. The innermost circle would represent the taxpayer’s real estate and tangible personal property. The middle concentric circle would represent the taxpayer’s total unit value. And the outermost concentric circle would represent the taxpayer’s total business value.

The analyst should be able to distinguish between these three different valuation subjects, and these three different valuation analyses. And the analyst should develop the valuation analysis that is appropriate to the property tax appraisal assignment.

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Robert F. Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a retired professional and former Managing Director of Willamette Management Associates, an independent consultant. He lives in Chicago and in his previous work at Willamette Management, which he is continuing, included business valuations, forensic analysis, and financial opinion services.

Mr. Reilly can be contacted at (847) 207-7210 or by e-mail to robertfreilly.cpa@gmail.com.